Vanguard: Flash Crash Comparison Not Apt for Wednesday’s Trading

By Brendan Conway

Investors still don’t know exactly what caused the heavy trading and volatile swings in about 150 stocks and a handful of exchange-traded funds this morning. But start with this: Today’s events aren’t much like the May 2010 “flash crash” in a few key respects.

Two years ago, as prices plunged, trading volume dried up. Procter & Gamble (PG) fell more than 30% for no particular reason. Orders to buy the stock were dollars apart simultaneously at different exchanges, showing that the market’s pricing mechanism had broken down. Market-structure experts were soon to debate “stub quotes” and other pratfalls.

Fast forward to this morning. Trading volume did the opposite — it surged. Stocks like RadioShack (RSH) and Bunge (BG) saw unusually heavy volume on volatile price swings. Some prices leapt. And no, none jumped to $100,000, like Apple (AAPL) briefly did in the flash crash.

We haven’t heard the last of this by any stretch. NYSE Euronext (NYX) has canceled trades in a handful of stocks. Knight Capital Group (KCG) will face more scrutiny over what it said was a software problem that affected trading in those 150 or so stocks, one that may be at the root of today’s issues. Investors will want to know exactly what happened and why and how it will be prevented in the future. For more on this, see my colleague Avi Salzman’s coverage, and the indispensable Jacob Bunge’s over at WSJ.com.

But Vanguard’s Joel Dickson is weighing in on the ETF portion of today’s unusual events — which, we’d point out, haven’t even been definitively tied to what went on in stocks at this point. Here, Dickson tells Barrons.com this afternoon that “I’m seeing a lot of comparisons made to the ‘flash crash,’ [and] I don’t think those comparisons are quite apt.”

For starters, in the ETFs at least, trading heated up after a number of orders were executed far away from the market price moments earlier.

That’s a suggestion that, once things got rocky — say, when a poorly executed trade went through, far from the previous market price — ETFs’ arbitrage pricing mechanism would have kicked in. If you’re new to this, here’s how it works.

Market participants, seeing that the ETF’s price had pulled far away from the underlying stocks, have the opportunity to push an ETF’s price back to the range where its index value or net-asset value is. The ETF, after all, is just a passively managed basket of stocks or other securities. Its value should roughly approximate the value of the stocks tracked by its index.

The arbitrageur thus can sell the overpriced ETF and buy the underpriced stocks simultaneously, until the prices converge. For the arbitrageur, that trade is free money when it works. And this is the mechanism that keeps passively managed ETFs tracking their benchmarks relatively closely.

“This was like someone in a busy shopping mall throwing a big bag of pennies,” Dickson, the senior investment strategist at Vanguard, told Barrons.com this afternoon. “Everybody started grabbing for them until the pennies were gone.”

Let’s break it down in the Vanguard Utilities Index exchange-traded fund (VPU). Examining this morning’s tape on FactSet Research Systems, the volume started to heat up when a rash of orders were executed close to 2% above the day’s first prints. FactSet shows heavy trading starting some time after 9:58 a.m. ET. Within minutes, the ETF hit as high as $84.92, or more than 5% above the previous day’s closing market price. That’s a massive move for a slow-moving utility fund tracking 80 or so stocks.

It’s also when the really heavy trading volume took place.

“There ended up being a price dislocation from the underlying value of the basket,” as Dickson puts it. “Very quickly people came in and narrowed that down to where it should be. The liquidity came in and the market mechanism came in like it’s supposed to.”

VPU wasn’t the only ETF to see unusually heavy trading early in Wednesday’s session. The Utilities Select Sector SPDR (XLU) is another, as is the United States Natural Gas Fund (UNG) and, to a lesser extent, the Market Vectors Gold Miners ETF (GDX).

About Focus on Funds

As exchange-traded funds and other investing vehicles have ballooned in number, the task of figuring out what works well and what doesn’t has only gotten harder. Barrons.com’s Focus on Funds looks under the hood of ETFs, mutual funds and hedge funds for overlooked values, actionable ideas and the latest pitfalls for fund investors.